America first, now Europe?

As investors assess the prospects for European markets relative to the US, Pierre-Henri Flamand considers some key drivers of US outperformance since the financial crisis. As these tailwinds potentially begin to fade, he argues that there is a growing case for Europe.

Introduction

A common question my team receives from clients is whether European markets have the potential to outperform the US over the coming months. Indeed, it seems like equity investors have been asking themselves this question for a number of years now, where the US has consistently outperformed since the Great Financial Crisis (GFC), with Europe struggling in the face of weak earnings and heightened political uncertainty. But could markets finally be reaching an inflection point?

With valuations in the US looking noticeably higher relative to history, this article argues the current case for Europe as an alternative. After considering relative valuations, it’s important to examine the causes of European markets’ substantial underperformance in recent years. We will look at three specific drivers of US outperformance: GDP growth, share repurchasing and the weight of technology in respective indices. We see potential opportunities in Europe, given an improving economic backdrop and potential political stabilisation. This piece focuses mainly on equities, but we will also consider opportunities from a credit perspective. Our team aims to generate risk-adjusted returns through alternative and long-only strategies, and we believe European markets may offer potentially fertile hunting ground.

It’s no secret that US equity valuations are high across most metrics versus history. Research by Goldman Sachs (Figure 1) suggests that US equities are currently in the 90th percentile compared to a 40-year period. The story is even more dramatic if we look at the median stock valuation, which has reached the 99th percentile. A similar study of European equities shows lower valuations versus history based on aggregate indices, in the 64th percentile, thanks largely to cheaper banks and resources companies weighing on averages. The median stock valuation is therefore at the 92nd percentile, not very far off the median stock in the US. Of course, while European equities may not be particularly cheap versus history, we feel they are more compelling versus bonds: against a backdrop of loose monetary policy, bond yields remain at record lows, and earnings yields have exceeded them since the early 2000s. Overall, we believe the relative case for Europe from a valuation perspective is more of a case for rotating out of the US after its run. To better understand this picture, it’s important to examine the reasons for US outperformance in recent years.

Figure 1. US and European valuation metrics

Source: Goldman Sachs, 2017. Data history is not available for certain metrics in Europe. Data is measured over the period since 1976 for all metrics other than PEG ratio (measured since 1982).

GDP growth, buy-backs and technology are sources of US outperformance – but won’t last forever

There are a number of broad headlines which partially explain US outperformance compared to Europe: for example, the Trump rally or strong US economic growth. We believe that US market outperformance since the GFC has been driven largely by earnings, and there are three key areas worth considering: GDP growth, share repurchasing and the weight of technology in respective indices. Each of these tailwinds has contributed to US outperformance, but none of them is likely to persist indefinitely in our view.

Premium for steady GDP growth

Global GDP growth expectations have consistently disappointed in recent years, but are beginning to turn around. Figure 2 shows consensus G7 real GDP growth expectations, which have tended to fall markedly over the course of each year, until recently when their paths are starting to flatten. In the years following the GFC, when growth disappointments were most pronounced, investors were willing to pay a significant premium for anything which could potentially deliver stable growth: the US was a natural choice here versus Europe. But this premium is beginning to fade. This year, for the first time in nearly a decade, the economies of all EU Member States are expected to achieve positive growth, and Europe entered its fifth consecutive year of recovery1. While US growth has been stronger than European growth in recent years, we believe that the two could equalise.

GDP growth has attracted investors to the US, but some elements of economic strength can also create headwinds for companies. For example, strong wage growth in the US has the potential to weigh on company operating margins, whereas sluggish wages in Europe mean less pressure from overhead spend. Figure 3 shows the path of wages in the Euro area versus the Atlanta Fed’s Wage Growth Tracker. With US unemployment at 4.3%, already falling through the Fed’s estimates of long-run normal rates (where the FOMC estimated a median of 4.6%2), the trend of positive wage growth seems established, so we find it hard to see how margins will hold up unless we see a substantial pick-up in productivity.

Share repurchasing and the impact of supply

Earnings have been a significant driver of US outperformance, and multiple expansion has been substantial. In recent years, US companies have undertaken a large number of buy-backs, increasing per-share earnings and value by reducing supply. This isn’t a new phenomenon: Figure 4 shows that the US has consistently seen greater repurchase levels than Europe, and the fact that this differential has been increasing in recent years has been supportive of US markets. Indeed, S&P 500 earnings per share (EPS) grew by 1% in 2016, but Goldman Sachs estimates that they may have fallen by 1.5% without the impact of buy-backs.

Figure 4. US versus European share buy-backs

Source: Goldman Sachs, 2017.

On the other hand, many European companies have taken the opposite path by conducting rights issues. In the main, this issuance has been by banks seeking to repair their balance sheets, and this activity has meant some dilution. Equity supply (or, the change in market cap not accounted for by price) has weighed on the performance of the Euro area in recent years.

But we cannot assume that either of these supply dynamics will continue indefinitely. While rights issues continue in Europe for now, banks have already made progress towards repairing their balance sheets, so this may slow down over time. In the US, repurchasing activity has already declined. As of May this year, S&P 500 companies had authorised $146bn in share buy-backs, down 15% from the same point last year and at the lowest pace in five years, according to Goldman Sachs3. This could be driven by equity risk premia decreasing in the US, meaning the arbitrage available to financially engineer growth is not as attractive as it was. Fewer buy-backs do not necessarily mean bad news for companies, but it is certainly a withdrawal of a significant tailwind for US markets.

US technology boost

The representation of technology in US stock indices has also driven outperformance. Tech’s rally in recent years has had a clear impact on their relative market performance, where the sector accounts for 23% of the S&P 500 in terms of index capitalisation, compared to just 5% of the Stoxx Europe 6004. As one example of the impact of this on market performance, Figure 5 shows the gap between operating margins of companies in US and European indices, which is close to a 30-year high. Once we strip out the impact of index technology weights, that gap is still significant, but it nearly halves.

Figure 5. Gap between US and European margins, including and excluding technology

Source: Goldman Sachs, 2017.

On top of their lower index weighting, European technology companies have also been out of favour, given their focus on business-related services rather than consumers. Indeed, the so-called ‘FAANGs’ (Facebook, Amazon, Apple, Netflix, Google) have substantially boosted US markets, and make up between 10-11% of the S&P 500’s total market capitalisation. Figure 6 shows the proportion of the S&P 500’s performance driven by these five stocks since the beginning of this year, recently over 40%. This is a significant contribution, presenting substantial potential risks through such a concentrated performance driver. It’s reasonable to believe that we may see a tipping point if markets accept that the Fed is properly embarked on a rate-rising cycle, and a reversal in performance of these companies could have a significant impact on US markets. On June 9th we saw a flicker of this, where an equal-weighted FAANG index fell 3.5%, before promptly recovering. We do not see fundamental drivers behind this short-lived move – perhaps a result of investors re-positioning around this crowded trade – but after a period of strong performance, we feel we may see a more persistent roll-over. On the other hand, an improving business environment in Europe could be a source of potential outperformance for European business-focused technology providers.

Figure 6. Proportion of S&P 500 performance contributed by FAANGs

Source: Bloomberg, 2017.

Divergence in earnings explains valuation differential

After looking at current valuations (the US looks expensive to us relative to its history, Europe slightly less so) and then the drivers of recent relative performance (GDP growth, buy-backs and technology), we should re-examine valuations in their proper context. Figure 7 shows US and European performance alongside EPS estimates. We can see that both markets have re-rated in proportion to expectations for earnings since the GFC.

Figure 7. Market performance and earnings estimates

By extension, the significant gap between US and European P/E seems driven by earnings. Figure 8 shows a computation of Shiller P/E (which strips out the impact of cyclical performance by incorporating average earnings over the past decade), and the gap between US and European markets is pronounced. Indeed, Europe’s Shiller P/E is only slightly above its long-term average5.

Figure 8. Shiller P/E in Europe and the US

Source: BCA Research, 2017.

If earnings growth explains this divergence between the US and Europe, and if there is reason to believe that the tailwinds for US companies may subside over the coming months, then the case for Europe as an alternative looks increasingly compelling in our view. This view is further supported by the equity risk premium (ERP) in Europe. Figure 9 shows the implied ERP for Europe and the US, as calculated by Goldman Sachs. Both regions are above their longer-term averages, but the implied ERP for Europe is substantially higher at 7.5%.

Figure 9. Implied equity risk premium: US and Europe

Source: Goldman Sachs, June 2017.

Tailwinds for Europe: Potential political stabilization and continued accommodative policy

Briefly, to the elephant in the room. The political backdrop in Europe has long been a source of concern for investors, and 2017 sees a number of significant elections. The result of the UK general election this month was unanticipated, leaving Britain’s Brexit negotiating position looking vulnerable under the leadership of a minority government. However, the immediate market response was relatively sanguine: major UK equity indices saw positive performance the day after the election6. While Brexit certainly dominates the headlines, there have also been a number of events which suggest that the rise of populism is starting to stutter. Macron’s election in France is one example of a significant change in Europe’s political tone, added to other establishment victories in Holland and Austria, plus signs that the populist 5-Star party is losing steam in Italy following local elections this month.

German federal elections are still to come later this year, and likely an Italian general election too. Again, the political backdrop seems to suggest that these could follow the same pattern in breaking the tide of populism. The majority of focus is likely to be on Germany as the EU’s biggest backer – and some in markets would see the appeal of a potential Schulz victory, forming a possibly powerful combination between a Social Democratic Chancellor and the reformist French President Macron. This would have the potential to strengthen political ties in Europe, perhaps moving the EU towards a more federalist system, including possible increased risk-sharing mechanisms (for example, a banking union or the creation of Eurobonds). Either way, the differences between Schulz and Merkel are relatively subtle when it comes to their approach to German engagement with the EU. But the most important thing about 2017 from a political perspective in Europe is that it potentially marks the end of a heavy electoral calendar in recent years. From 2018, general election risk will likely be taken off the table for the next few years (with the possible exception of the UK). Of course, elections are only one source of political risk: and it is possible that markets may still get stuck trading the headlines rather than thinking about longer-term realities as Brexit negotiations begin. But overall, fewer general elections may create a firmer picture of EU Member States’ positions on Europe (and Brexit), and fewer binary outcomes for markets to chase.

Beyond politics, we believe monetary policy will also be important. In the US, strong growth and low unemployment have set the scene for further tightening, where the Fed’s rate hike this month continues the rising cycle. On the other hand, low wage growth and continued uncertainty in Europe mean that all eyes will be on the European Central Bank (ECB) as it treads the line between steady economic progress and the fact that inflation remains far from its 2% target. Overall, we do not expect any sudden movements from the ECB, and believe that real tapering remains a way off, which could help continue to support European equity markets.

A case for credit? European bonds require bottom-up security selection

But could the tailwinds for European equity markets also mean a positive outlook for credit? Clearly central bank policy is likely to remain a focus for fixed income investors, with the ECB’s bond-buying programme an attempt to support inflation and stimulate growth in the Eurozone. But while broader macro and market dynamics have a role to play, and our team believes that unfolding political and policy dynamics may throw up dislocations over the coming months, our focus is on bottom-up security selection. Spreads continue to tighten across global credit markets, and we believe the most effective focus is on idiosyncratic and company-specific risk.

As Europe continues its recovery following the GFC, banks continue their clean-up process. We mentioned earlier that banks had come some way in repairing their balance sheets, and indeed recent regulatory changes (including Basel III and Solvency II) require banks and insurance companies to hold more capital against their investments. In response, highly complex hybrid debt instruments have evolved, providing new types of capital. We believe that these vehicles may provide opportunities for investors, but only those with deep understanding at a company level are likely to be able to benefit.

At the same time, the European banking sector remains under significant pressure. One recent example of this is Banco Popular Espanol, where the regulator and resolution authorities announced a ‘bail in’ of their subordinated debt before a sale to Santander at the price of €1. This is a good illustration of how special situations within distressed financials can present interesting opportunities, where spreads widened throughout the capital structure as Banco Popular’s failure became more likely. This was a demonstration of a new-style ‘resolution’ of a failing bank, and we may potentially see similar situations going forward. Positioning in these distressed institutions requires a detailed understanding of legal and regulatory frameworks, as well as active involvement in the process itself. In the case of Banco Popular, investors who took risk in senior debt, with a solid understanding of the options available to the authorities, have been rewarded so far, while subordinated debt investors have experienced losses. When considering opportunities like this, we believe that bottom-up research trumps top-down perspectives.

Ways to play Europe

As with many investment opportunities, we believe the most attractive points of entry to Europe are unlikely to present themselves in a linear fashion. At Man GLG, we do not believe in one ‘correct’ way to invest, and our team uses a broad spectrum of alternative and long-only strategies to seek positive risk-adjusted performance. Among the common themes our team is thinking about going forward are banking reflation (we’ve already highlighted that bank recapitalisation in Europe is underway), construction recovery (where we feel companies in this area can continue to make progress) and recovery or ‘self-help’ stories (with a number of potential individual turnaround prospects in Europe, bottom-up security selection will be important across asset classes in our view). We believe there will be multiple opportunities to potentially add value in Europe over the coming months. For our equity strategies, our team’s focus will be on understanding the implications of broad market dynamics and combining this with detailed bottom-up research into European companies. Among our credit strategies, the focus rightly remains on security-specific and idiosyncratic risk, with our teams remaining alert to individual potential opportunities which may come up as Europe’s story unfolds.

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